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Based on the recommended readings and your own experience, post a 100 word minimum response to the following discussion question. Please, make sure your answer reflects your own words and critical thinking.

Responses must be written in APA style. In-text citations and references are required when utilizing outside sources of any kind. Review the citation requirements located under the Week 1 Course Materials, Discussion Rubric. 

Answer all parts to the discussion question.

A) Why is the budgeting process important to a business? 

B) What does the term “the bottom line” mean to an organization?

C) Share your experience in working with a budget. 


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Confirming Pages part Financing the Enterprise W I L S O N , 6 J A M CHAPTER 14 Accounting and Financial Statements I E the Financial System CHAPTER 15 Money and CHAPTER 16 Financial 5 Management and Securities Markets 0 Financial Planning APPENDIX D Personal 5 1 B U fer11722_ch14_421-457.indd 421 9/22/08 2:18:58 PM Confirming Pages chapter 14 CHAPTER OUTLINE Introduction The Nature of Accounting Accountants Accounting or Bookkeeping? The Uses of Accounting Information Accounting and Financial W I Statements L S O N , The Accounting Process The Accounting Equation Double-Entry Bookkeeping The Accounting Cycle Financial Statements The Income Statement The Balance Sheet The Statement of Cash Flows Ratio Analysis: Analyzing Financial Statements Profitability Ratios Asset Utilization Ratios Liquidity Ratios Debt Utilization Ratios Per Share Data Industry Analysis OBJECTIVES J After reading this chapter, A you will be able to: • Define accounting, andM describe the different uses of accounting information. I • Demonstrate the accounting process. E • Examine the various components of an income statement in order to evaluate a firm’s “bottom line.” 5 • Interpret a company’s balance sheet to determine its current finan0 cial position. 5 • Analyze financial statements, using ratio analysis, to evaluate a company’s performance. 1 • Assess a company’s financial position using its accounting stateB ments and ratio analysis. U fer11722_ch14_421-457.indd 422 9/22/08 2:18:59 PM W I L S The Richest Man in the World O It is, after all, possible to be richer than Microsoft’sNBill Gates. For a brief time , in 2007, Fortune magazine listed the Mexican telecommunications tycoon, Carlos Slim Helú, at the top of the list. By 2008, Slim slipped back to number two, with a fortune of $60 billion, while Warren Buffet J took the number-one spot with net worth of $62 billion. The son of Lebanese immigrants, Slim is a A self-made man. Dabbling in soft drinks, printing, and tobacco in the 1960s and M by purchasing a num1970s, Slim managed to profit off the 1982 fiscal crisis I the country’s economy ber of companies for a fraction of their worth. When E to realize considerable bounced back at the end of the decade, Slim began profits. For example, he purchased Mexico’s largest insurance company for $44 million, and it is now worth around $2.5 billion. 5 However, Slim did not make his first real fortune until 1990, when he bought the formerly national0 ized telephone company Teléfonos de México (Telmex). 5 Today, Slim owns more than 200 companies, and his wealth comprises 1 nearly 8 percent of Mexico’s entire GDP. Slim’s affluence is growing at a fast B 2005. In Mexico, Slim pace; it has increased by more than $20 billion since has been dubbed “Mr. Monopoly,” because of hisUstaggering wealth and the market dominance of Telmex. Although Mexico has been privatizing industries since the 1990s, competition in the telephone industry has not increased. Telmex still controls 92 percent of Mexico’s phone lines and 73 percent of cell phones. Slim’s critics complain that his stranglehold on the national phone service has actually slowed development in the country. To date, only 20 percent of Mexican residents have phone service, a number that remains low because ENTER THE WORLD OF BUSINESS Confirming Pages continued fer11722_ch14_421-457.indd 423 9/22/08 2:18:59 PM Confirming Pages of the high price of service, according to the Organization for Cooperation and Economic Development. Many believe that Slim’s rates have kept Mexican businesses from profiting and paying their workers as well as they should. It has always been Slim’s modus operandi to purchase companies when the price is low and then begin to force the competition out of the market. Mexico’s slow economic growth and lack of good jobs has fueled illegal immigration into the United States, where jobs are perceived as plentiful and the quality of life as higher. However, increasing illegal immigration has put a financial strain on the U.S. government, while decreasing the supply of workers in Mexico—further slowing development. Lack of competition not only halts development. It also decreases the quality of services and accountability and encourages dishonest accounting W practices. Along with most of Latin America, Mexico has dealt with monopI olies since Colonial times. In power for around 70 years, the political party L the Partido Revolucionario Institutional (PRI) represented one of the longestS the Western hemisphere. The party faced little lasting hegemonic powers in or no opposition from 1929 to Othe early 1990s. During this time, most monopolies were state owned and run. N Finally, in the 1990s privatization movements, coupled with the PRI’s loss of power, allowed private investors to step in and , buy out many state-owned companies. The monopolies did not end there, however, with Slim being the preeminent example of a private monopolisJ Felipe Calderón, has taken a public stance tic power. Mexico’s president, ATelmex and has held talks with Slim over the against such monopolies as issue. However, large companies M like Telmex tend to receive special treatment from the government,Igiven the huge amount of money and resources they control. Slim himself claims that he welcomes competition and that his E actions, including his accounting practices, are transparent—but his behavior says otherwise. 5 that he runs monopolies, the Federal ComWhether or not Slim believes 0 plans to investigate Slim. In 1998 the FCC munications Commission (FCC) found Telmex guilty of colluding 5 with Sprint to overcharge for long distance services. It is possible that1new findings could result in stiffer regulations and calls for more transparent accounting practices. More rules might also B have a long-term impact on Slim’s wealth. As with many of the other richest U men in the world, much of Slim’s financial success depends on stock prices, which depend on high performance. Increased oversight could call attention to unethical accounting and other issues, which could cause prices to drop, and his wealth would follow.1 424 fer11722_ch14_421-457.indd 424 9/22/08 2:19:08 PM Confirming Pages CHAPTER 14 Accounting and Financial Statements 425 Introduction Accounting, the financial “language” that organizations use to record, measure, and interpret all of their financial transactions and records, is very important in business. All businesses—from a small family farm to a giant corporation—use the language of accounting to make sure they use their money wisely and to plan for the future. Nonbusiness organizations such as charities and governments also use accounting to demonstrate to donors and taxpayers how well they are using their funds and meeting their stated objectives. This chapter explores the role of accounting in business and its importance in making business decisions. First, we discuss the uses of accounting information and the accounting process. Then, we briefly look at some simple financial statements W and accounting tools that are useful in analyzing organizations worldwide. I L Simply stated, accounting is the recording, measurement, and interpretation of S financial information. Large numbers of people and institutions, both within and outside businesses, use accounting tools to evaluateO organizational operations. The Financial Accounting Standards Board has been setting N the principles standards of financial accounting and reporting in the private sector since 1973. Its mission is to , and reporting for the guidestablish and improve standards of financial accounting The Nature of Accounting accounting the recording, measurement, and interpretation of financial information ance and education of the public, including issuers, auditors, and users of financial information. However, the accounting scandals at the turn of the last century resulted J when many accounting firms and businesses failed to abide by generally accepted accounting principles, or GAAP. More than 1,000 firms A ultimately reported flaws in their financial statements between 1997 and 2002; in 2002 alone, a record 330 comM panies chose to restate their earnings to avoid further questions.2 Consequently, the I rules, requirements, and polifederal government has taken a greater role in making cies for accounting firms and businesses through theESecurities and Exchange Commission’s (SEC) Public Company Accounting Oversight Board. For example, Ernst & Young, a leading accounting firm, was barred from undertaking new audit clients for six months as penalty for abusing the agency’s auditor-independence rules.3 5 To better understand the importance of accounting, we must first understand who prepares accounting information and how it is 0 used. 5 1 B U fer11722_ch14_421-457.indd 425 9/22/08 2:19:08 PM Rev. Confirming Pages 426 PART 6 Financing the Enterprise Accountants Many of the functions of accounting are carried out by public or private accountants. Public Accountants. Individuals and businesses can hire a certified public accountant (CPA), an individual who has been certified by the state in which he or she practices to provide accounting services ranging from the preparation of financial records and the filing of tax returns to complex audits of corporate financial records. Certification gives a public accountant the right to express, officially, an unbiased opinion regarding the accuracy of the client’s financial statements. Most public accountants are either self-employed or members of large public accounting firms such as Ernst & Young, KPMG, Deloitte & Touche, and PricewaterhouseCoopers, together referred to as “the Big Four.” In addition, many CPAs work for one of the second-tier accounting W firms that are much smaller than the Big Four firms, as illustrated in Table 14.1. The accounting scandals at the turn of the cenItury, combined with more stringent accounting Lrequirements legislated by the Sarbanes-Oxley have increased job prospects for accountants SAct, and students with accounting degrees as comO panies and accounting firms hire more auditors to satisfy the law and public demand for greater N transparency.4 , With the demise of Arthur Andersen there have been concerns about one of the remaining Big Four accounting firms failing. The U.S. Chamber of ComJmerce published a report calling for regulators and policy makers to keep such an event from happenA ing again to maintain competition and availability M of accountants.5 The insurance and financial services provider AIG is among the many U.S. firms hiring more forensic accountants. Forensic accountants I A growing area for public accountants is forensic utilize their accounting, auditing, and investigative skills to check the accounting, which is accounting that is fit for legal Ereview. It involves analyzing financial documents books of companies. in search of fraudulent entries or financial misconduct. Functioning as much like detectives as accountants, forensic accountants have been used since the 1930s. In the 5 of the accounting scandals of the early 2000s, wake many 0 auditing firms are rapidly adding or expandDid You Know? Corporate fraud costs are ing 5 forensic or fraud-detection services. Additionestimated at $600 billion annually.6 ally, many forensic accountants root out evidence of 1 “cooked books” for federal agencies like the Federal Bureau of Investigation or the B Internal Revenue Service. The Association of Certified Fraud Examiners, which certifies accounting professionals as certified fraud examiners (CFEs), has grown toU more than 45,000 members.7 certified public accountant (CPA) an individual who has been state certified to provide accounting services ranging from the preparation of financial records and the filing of tax returns to complex audits of corporate financial records fer11722_ch14_421-457.indd 426 9/23/08 10:59:18 AM Rev. Confirming Pages CHAPTER 14 Accounting and Financial Statements 2007 Revenues ($ Millions) 2008 VAULT Accounting Firm Prestige Rankings PricewaterhouseCoopers $25,150 7.616 Company “Big Four” Ernst & Young 21,100 7.415 Deloitte & Touche 9,800 7.035 KPMG 19,800 6.447 Grant Thornton 1,075 6.009 BDO Seidman 589 5.720 427 TABLE 14.1 Leading Accounting Firms Second-Tier Firms W 5.708 I Source: “Accounting Firm Rankings,” “Vault Top 40 Accounting Firms,” www.vault.com/nr/finance_rankings/ accounting_rankings.jsp?accounting2008⫽2 (accessed May 20, 2008). L S O Private Accountants. Large corporations, government agencies, and other organizations may employ their own private accountants N to prepare and analyze their financial statements. With titles such as controller, tax accountant, or internal audi, tor, private accountants are deeply involved in many of the most important financial McGladrey & Pullen 1,300 decisions of the organizations for which they work. Private accountants can be CPAs and may become certified management accountants (CMAs) by passing a J rigorous examination by the Institute of Management Accountants. A M The terms accounting and bookkeeping are often mistakenly used interchangeably. I Much narrower and far more mechanical than accounting, bookkeeping is typically limited to the routine, day-to-day recording of business transactions. BookkeepE Accounting or Bookkeeping? ers are responsible for obtaining and recording the information that accountants require to analyze a firm’s financial position. They generally require less training than accountants. Accountants, on the other hand,5usually complete course work beyond their basic four- or five-year college accounting degrees. This additional 0 information, but to undertraining allows accountants not only to record financial stand, interpret, and even develop the sophisticated accounting systems necessary to 5 classify and analyze complex financial information. private accountants accountants employed by large corporations, government agencies, and other organizations to prepare and analyze their financial statements certified management accountants (CMAs) private accountants who, after rigorous examination, are certified by the National Association of Accountants and who have some managerial responsibility 1 B The Uses of Accounting Information Accountants summarize the information from a firm’s U business transactions in various financial statements (which we’ll look at in a later section of this chapter) for a variety of stakeholders, including managers, investors, creditors, and government agencies. Many business failures may be directly linked to ignorance of the information “hidden” inside these financial statements. Likewise, most business successes can be traced to informed managers who understand the consequences of their decisions. While maintaining and even increasing short-run profits is desirable, the failure to plan sufficiently for the future can easily lead an otherwise successful company to insolvency and bankruptcy court. Basically, managers and owners use financial statements (1) to aid in internal planning and control and (2) for external purposes such as reporting to the Internal fer11722_ch14_421-457.indd 427 9/23/08 10:58:37 AM Confirming Pages 428 PART 6 Financing the Enterprise Revenue Service, stockholders, creditors, customers, employees, and other interested parties. Figure 14.1 shows some of the users of the accounting information generated by a typical corporation. managerial accounting the internal use of accounting statements by managers in planning and directing the organization’s activities cash flow the movement of money through an organization over a daily, weekly, monthly, or yearly basis budget an internal financial plan that forecasts expenses and income over a set period of time Internal Uses. Managerial accounting refers to the internal use of accounting statements by managers in planning and directing the organization’s activities. Perhaps management’s greatest single concern is cash flow, the movement of money through an organization over a daily, weekly, monthly, or yearly basis. Obviously, for any business to succeed, it needs to generate enough cash to pay its bills as they fall due. However, it is not at all unusual for highly successful and rapidly growing companies to struggle to make payments to employees, suppliers, and lenders because of an inadequate cash flow. One common reason for a so-called “cash crunch,” or shortfall, is poor Wmanagerial planning. Managerial accountants also help prepare an organization’s budget, an internal financial plan that forecastsI expenses and income over a set period of time. It is not unusual for an organization L to prepare separate daily, weekly, monthly, and yearly budgets. Think of a budget as a financial map, showing how the company expects to move from Point A toSPoint B over a specific period of time. While most companies prepare master budgets O for the entire firm, many also prepare budgets for smaller segments of the organization such as divisions, departments, product N budgets begin at the upper management level lines, or projects. “Top-down” master and filter down to the individual, department level, while “bottom-up” budgets start at the department or project level and are combined at the chief executive’s office. Generally, the larger and more rapidly growing an organization, the greater will be the likelihood that it will build its J master budget from the ground up. Regardless of focus, the principal value of a budget lies in its breakdown of cash A inflows and outflows. Expected operating expenses (cash outflows such as wages, M materials costs, and taxes) and operating revenues (cash inflows in the form of payments from customers) over a Iset period of time are carefully forecast and subsequently compared with actual results. Deviations between the two serve as a “trip E FIGURE 14.1 The Users of Accounting Information Source: Belverd E. Needles, Henry R. Anderson, and James C. Caldwell, Principles of Accounting, 4th edition. Copyright © 1990 by Houghton Mifflin Company. Reprinted with permission. Management Owners, partners Boards of directors Officers of the company Managers Department heads Supervisors 5 0 5 1 Those with Direct B Financial Interest Present or U potential investors Present or potential creditors Business Activities Accounting Tax Authorities Federal (IRS) State Municipal Other Those with Indirect Financial Interest Economic Regulatory Other Planners Agencies Groups SEC Stock exchanges ICC, FAA, etc. Other agencies Council of Economic Advisors Federal Reserve Board Government planners Employees and labor unions Financial advisors Customers and the general public Actions That Affect Business Activities fer11722_ch14_421-457.indd 428 9/22/08 2:19:17 PM Confirming Pages CHAPTER 14 Accounting and Financial Statements 429 wire” or “feedback loop” to launch more detailed financial analyses in an effort to pinpoint trouble spots and opportunities. External Uses. Managers also use accounting statements to report the business’s financial performance to outsiders. Such statements are used for filing income taxes, obtaining credit from lenders, and reporting results to the firm’s stockholders. They become the basis for the information provided in the official corporate annual report, a summary of the firm’s financial information, products, and growth plans for owners and potential investors. While frequently presented between slick, glossy covers prepared by major advertising firms, the single most important component of an annual report is the signature of a certified public accountant attesting that the required financial statements are an accurate reflection of the underlying financial condition of the firm. Financial statements meeting W these conditions are termed audited. The primary external users of audited accounting information are governI and lenders, suppliers, and ment agencies, stockholders and potential investors, employees. L Federal, state, and local governments (both domestic and overseas) require orgaS nizations to file audited financial statements concerning taxes owed and paid, payroll deductions for employees, and, for corporations,O new issues of securities (stocks and bonds). Even nonprofit corporations and other nonbusiness organizations N may be required to file regular financial statements. While corporations make the , news most frequently for financial scandals, even governments are not immune to accounting problems. Germany’s free-market party, the Freie Demokratische Partei or FDP, has been accused of falsely accounting for more than €1.66 million, or $2.5 million, in party donations between 1996 and 2000.JUnder the leadership of nowdeceased Juergen Moelleman, the party was guilty ofAserious ethical and accounting infractions—including hiding large donations by recording them as small donaM to remedy the situation and tions under false names. The federal treasury is seeking is fining the party €5 million. Because of the wronglyI accounted for donations, all of the party’s financial statements are also being called into question by parliamentary E million.8 Like individuals, auditors, which could cost the FDP an additional €7.24 well-managed companies generally try to minimize their taxable income by using accepted accounting practices. Usually, accounting practices that reduce taxes also reduce reported profits. By reducing taxes, the firm5increases the cash available to the firm that can be used for many purposes, such 0 as plant expansion, debt retirement, or repurchase of common stock. 5 A corporation’s stockholders use financial statements to evaluate the return on their investment and the overall quality of the 1 firm’s management team. As a result, poor performance, as documented in the financial B statements, often results in changes in top management. Potential investors study the financial statements in U a firm’s annual report to determine whether the company meets their investment requirements and whether the returns from a given firm are likely to compare favorably with other similar companies. Banks and other lenders look at financial statements to determine a company’s ability to meet current and future debt obligations if a loan or credit is granted. To determine this ability, a short-term lender examines a firm’s cash flow to assess its ability to repay a loan quickly with cash generated from sales. A long-term lender is more interested in the company’s profitability and indebtedness to other lenders. Labor unions and employees use financial statements to establish reasonable expectations for salary and other benefit requests. Just as firms experiencing record profits are likely to face added pressure to increase employee wages, so too are fer11722_ch14_421-457.indd 429 annual report summary of a firm’s financial information, products, and growth plans for owners and potential investors 9/22/08 2:19:18 PM Confirming Pages Going Green Hertz Goes Green: Generating Cost versus Benefit Decisions As gas prices and concern for the environment grow, the demand for hybrids and fuel-efficient cars is also on the rise. Among those answering the call is the rental car company Hertz. In 2006, Hertz launched its Green Collection, which originally included four makes: Toyota Camry, Ford Fusion, Buick LaCrosse, and Hyundai Sonata. All of these cars have a fuel efficiency of 28 mpg or more, earning them a high EPA SmartWay rating. The EPA SmartWay rating system examines air pollution and greenhouse gas emissions. Cars are ranked on a scale of 0 to 10 for each criterion, with 10 being the highest and 5 being average. All Hertz Green Collection cars must score at least a 6 on both. In 2007, Hertz added the Toyota Prius to its line of Green cars. With SmartWay Elite ratings of 9.5 for air pollution and 10 for greenhouse gas emissions, the Prius holds the highest ranking in the Hertz fleet and possesses one of the highest ratings on the market today. For consumers seeking to be eco-friendly even when away from their normal car, the Green Collection from Hertz is helping make it easier for car renters to make environmentally responsible decisions. While, Hertz’s eco-friendly line is still a tiny part of its overall fleet, with offerings at only around 50 airports nationwide, the company is working to expand this number. During 2007, Hertz purchased nearly 4,500 Priuses, a move that cost the company more than $65 million. The company is also working to expand the availability of ethanol-fueled cars throughout the Midwest, where corn ethanol is plentiful. The Green Collection costs around $5 to $10 per day more than renting a regular car, which means those not interested in environmental issues are not likely to rent from the Green collection. Business travelers might also be forbidden from renting more expensive cars by their company’s accounting policies. Hertz claims that most drivers will make up the cost differential in fuel savings, although this depends on the model and how much driving a renter does. Even if this is true, for business travelers who must watch their costs, new accounting policies may need to be put in place that specify what kinds of cars employees can rent and whether they include more expensive but more fuel-efficient models. Some analysts who support this “green” movement in the rental car industry have also expressed concern that consumers will balk at paying an additional fee to drive a more efficient car. WNo one is arguing, however, that moving toward a more fuelefficient fleet is a smart step for Hertz. The company recently I stated that by adding 1,000 hybrids to its fleet, it will reduce L dioxide emissions by about 3,000 tons annually. In addicarbon tion, S Hertz now donates $1 to the National Park Foundation for each Green Collection car rental. If you believe that every little O counts, then an extra $5 to $10 a day for a Prius or Camry step 9 the Nnext time you need to rent a car is a small price to pay. , Discussion Questions 1. Aside from helping the environment, what are some of the advantages of Hertz adding a Green Collection to its fleet? 2.JThe up-front cost of acquiring thousands of eco-friendly cars is very high for Hertz. What is Hertz anticipating Aabout consumer tastes and demands that would allow it Mto justify such a large expense? 3. How could positioning itself as the eco-friendly rental I company that has low-emissions cars and donates to environmental causes help Hertz’s bottom line? E 5 employees unlikely to grant employers wage and benefit concessions without considerable evidence of financial distress. 0 5 The Accounting Process 1 Many view accounting as a primary business language. It is of little use, however, B it. Fortunately, the fundamentals—the accountunless you know how to “speak” ing equation and the double-entry U bookkeeping system—are not difficult to learn. These two concepts serve as the starting point for all currently accepted accounting principles. assets a firm’s economic resources, or items of value that it owns, such as cash, inventory, land, equipment, buildings, and other tangible and intangible things The Accounting Equation Accountants are concerned with reporting an organization’s assets, liabilities, and owners’ equity. To help illustrate these concepts, consider a hypothetical floral shop called Anna’s Flowers, owned by Anna Rodriguez. A firm’s economic resources, or items of value that it owns, represent its assets—cash, inventory, land, equipment, buildings, and other tangible and intangible things. The assets of Anna’s Flowers include counters, refrigerated display cases, flowers, decorations, vases, cards, 430 fer11722_ch14_421-457.indd 430 9/22/08 2:19:18 PM Rev. Confirming Pages CHAPTER 14 Accounting and Financial Statements and other gifts, as well as something known as “goodwill,” which in this case is Anna’s reputation for preparing and delivering beautiful floral arrangements on a timely basis. Liabilities, on the other hand, are debts the firm owes to others. Among the liabilities of Anna’s Flowers are a loan from the Small Business Administration and money owed to flower suppliers and other creditors for items purchased. The owners’ equity category contains all of the money that has ever been contributed to the company that never has to be paid back. The funds can come from investors who have given money or assets to the company, or it can come from past profitable operations. In the case of Anna’s Flowers, if Anna were to sell off, or liquidate, her business, any money left over after selling all the shop’s assets and paying off its liabilities would comprise her owner’s equity. The relationship between assets, liabilities, and owners’ equity is a fundamental concept in accounting and is known W as the accounting equation: I equity Assets ⫽ Liabilities ⫹ Owner’s L S Double-entry bookkeeping is a system of recording and classifying business transactions in separate accounts in order to maintain the balance of the accounting O equation. Returning to Anna’s Flowers, suppose Anna buys $325 worth of roses on N order. When she records this credit from the Antique Rose Emporium to fill a wedding transaction, she will list the $325 as a liability or a debt, to a supplier. At the same time, 431 liabilities debts that a firm owes to others owners’ equity equals assets minus liabilities and reflects historical values accounting equation assets equal liabilities plus owners’ equity Double-Entry Bookkeeping however, she will also record $325 worth of roses as an asset in an account known as “inventory.” Because the assets and liabilities are on different sides of the accounting equation, Anna’s accounts increase in total size (by $325) J but remain in balance: double-entry bookkeeping a system of recording and classifying business transactions that maintains the balance of the accounting equation Assets ⫽ Liabilities ⫹ Owner’s Aequity $325 ⫽ $325 M Thus, to keep the accounting equation in balance, each I business transaction must be recorded in two separate accounts. E In the final analysis, all business transactions are classified as either assets, liabilities, or owners’ equity. However, most organizations further break down these three accounts to provide more specific information about a transaction. For example, 5 as cash, inventory, and equipassets may be broken down into specific categories such ment, while liabilities may include bank loans, supplier 0 credit, and other debts. Figure 14.2 shows how Anna used the double-entry bookkeeping system to account for all of the transactions that took place 5 in her first month of business. These transactions include her initial investment of 1 $2,500, the loan from the Small Business Administration, purchases of equipment and inventory, and the purchase B generated revenues of $2,000 of roses on credit. In her first month of business, Anna by selling $1,500 worth of inventory. Thus, she deducts, U or (in accounting notation that is appropriate for assets) credits, $1,500 from inventory and adds, or debits, $2,000 to the cash account. The difference between Anna’s $2,000 cash inflow and her $1,500 outflow is represented by a credit to owners’ equity, because it is money that belongs to her as the owner of the flower shop. The Accounting Cycle In any accounting system, financial data typically pass through a four-step procedure sometimes called the accounting cycle. The steps include examining source documents, recording transactions in an accounting journal, posting recorded transactions, and preparing financial statements. Figure 14.3 shows how Anna works fer11722_ch14_421-457.indd 431 accounting cycle the four-step procedure of an accounting system: examining source documents, recording transactions in an accounting journal, posting recorded transactions, and preparing financial statements 9/23/08 11:58:21 AM Confirming Pages 432 PART 6 Financing the Enterprise FIGURE 14.2 The Accounting Equation and Double-Entry Bookkeeping for Anna’s Flowers W I L S O N , J through them. Traditionally, all of these steps were performed using paper, pencils, and erasers (lots of erasers!), butAtoday the process is often fully computerized. M Step One: Examine Source Documents. Like all good managers, Anna Rodriguez begins the accounting cycleI by gathering and examining source documents— checks, credit-card receipts, sales slips, and other related evidence concerning specific E transactions. journal a time-ordered list of account transactions ledger a book or computer file with separate sections for each account Step Two: Record Transactions. Next, Anna records each financial transac5 just a time-ordered list of account transactions. tion in a journal, which is basically While most businesses keep a general 0 journal in which all transactions are recorded, some classify transactions into specialized journals for specific types of transaction 5 accounts. 1 Anna next transfers the information from her Step Three: Post Transactions. journal into a ledger, a book B or computer program with separate files for each account. This process is known as posting. At the end of the accounting period (usuU or monthly), Anna prepares a trial balance, a ally yearly, but occasionally quarterly summary of the balances of all the accounts in the general ledger. If, upon totalling, the trial balance doesn’t (that is, the accounting equation is not in balance), Anna or her accountant must look for mistakes (typically an error in one or more of the ledger entries) and correct them. If the trial balance is correct, the accountant can then begin to prepare the financial statements. Step Four: Prepare Financial Statements. The information from the trial balance is also used to prepare the company’s financial statements. In the case of public corporations and certain other organizations, a CPA must attest, or certify, that the organization followed generally accepted accounting principles fer11722_ch14_421-457.indd 432 9/22/08 2:19:20 PM Confirming Pages CHAPTER 14 Accounting and Financial Statements 433 FIGURE 14.3 The Accounting Process for Anna’s Flowers W I L S O N , J A M I E 5 0 5 1 B U fer11722_ch14_421-457.indd 433 9/22/08 2:19:22 PM Confirming Pages 434 PART 6 Financing the Enterprise in preparing the financial statements. When these statements have been completed, the organization’s books are “closed,” and the accounting cycle begins anew for the next accounting period. Financial Statements The end result of the accounting process is a series of financial statements. The income statement, the balance sheet, and the statement of cash flows are the best-known examples of financial statements. They are provided to stockholders and potential investors Wa firm’s annual report as well as to other relevant in outsiders such as creditors, government agencies, I and the Internal Revenue Service. L It is important to recognize that not all financial statements follow precisely the same format. The fact S that different organizations generate income in difO ways suggests that when it comes to financial ferent statements, one size definitely does not fit all. ManuN facturing firms, service providers, and nonprofit , organizations each use a different set of accounting principles or rules upon which the public accounting profession has agreed. As we have already menJ tioned, these are sometimes referred to as generally accepted accounting principles (GAAP). Each country A has a different set of rules that the businesses within M Grant Thorton LLP provides comprehensive accounting services such that country are required to use for their accounting as auditing of financial statements to its clients. process and financial statements. Moreover, as is the I case in many other disciplines, certain concepts have E more than one name. For example, sales and revenues are often interchanged, as are profits, income, and earnings. Table 14.2 lists a few common equivalent terms that should help you decipher their meaning in accounting statements. 5 TABLE 14.2 Term Equivalent Terms in Accounting Revenues Gross profit 0 5 1 B U Operating income Income before taxes (IBT) Net income (NI) Income available to common stockholders fer11722_ch14_421-457.indd 434 Equivalent Term Sales Goods or services sold Gross income Gross earnings Operating profit Earnings before interest and taxes (EBIT) Income before interest and taxes (IBIT) Earnings before taxes (EBT) Profit before taxes (PBT) Earnings after taxes (EAT) Profit after taxes (PAT) Earnings available to common stockholders 9/22/08 2:19:25 PM Confirming Pages CHAPTER 14 Accounting and Financial Statements 435 The Income Statement The question, “What’s the bottom line?” derives from the income statement, where the bottom line shows the overall profit or loss of the company after taxes. Thus, the income statement is a financial report that shows an organization’s profitability over a period of time, be that a month, quarter, or year. By its very design, the income statement offers one of the clearest possible pictures of the company’s overall revenues and the costs incurred in generating those revenues. Other names for the income statement include profit and loss (P&L) statement or operating statement. A sample income statement with line-by-line explanations is presented in Table 14.3, income statement a fianancial report that shows an organization’s profitability over a period of time—month, quarter, or year W The following exhibit presents a sample income statementI with all the terms defined and explained. Company Name for the Year Ended December 31 L Revenues (sales) Total dollar amount of Sproducts sold (includes income from other business services such as rental-lease income and interest income). Othe goods and services, including the cost of labor and raw Less: Cost of goods sold The cost of producing materials as well as other expenses associated with production. N Gross profit The income available after paying all expenses of production. , Less: Selling and administrative The cost of promoting, advertising, and selling products as well as the overhead TABLE 14.3 Sample Income Statement expense Income before interest and taxes (operating income or EBIT) Less: Interest expense Income before taxes (earnings before taxes—EBT) Less: Taxes Net income Less: Preferred dividends costs of managing the company. This includes the cost of management and corporate staff. One non-cash expense included in this category is depreciation, which approximatesJ the decline in the value of plant and equipment assets due to use over time. In most accounting statements, depreciation is not separated from A expenses. However, financial analysts usually create selling and administrative statements that include M this expense. This line represents all income left over after operating expenses have been I deducted. This is sometimes referred to as operating income since it represents all income after the expenses of operations have been accounted for. Occasionally, E this is referred to as EBIT, or earnings before interest and taxes. Interest expense arises as a cost of borrowing money. This is a financial expense rather than an operating expense and is listed separately. As the amount of debt 5 and the cost of debt increase, so will the interest expense. This covers the cost of both short-term and 0 long-term borrowing. The firm will pay a tax on this amount. This is what is left of revenues after 5 costs, depreciation costs, and interest costs. subtracting all operating 1 in the federal tax code. The tax rate is specified This is the amount ofB income left after taxes. The firm may decide to retain all or a portion of the income for reinvestment in new assets. Whatever it decides not to keep it will usually pay Uout in dividends to its stockholders. If the company has preferred stockholders, they are first in line for dividends. That is one reason why their stock is called “preferred.” Income to common stockholders This is the income left for the common stockholders. If the company has a good year, there may be a lot of income available for dividends. If the company has a bad year, income could be negative. The common stockholders are the ultimate owners and risk takers. They have the potential for very high or very poor returns since they get whatever is left after all other expenses. Earnings per share Earnings per share is found by taking the income available to the common stockholders and dividing by the number of shares of common stock outstanding. This is income generated by the company for each share of common stock. fer11722_ch14_421-457.indd 435 9/22/08 2:19:32 PM Rev. Confirming Pages 436 PART 6 revenue the total amount of money received from the sale of goods or services, as well as from related business activities while Table 14.4 presents the income statement of Starbucks. The income statement indicates the firm’s profitability or income (the bottom line), which is derived by subtracting the firm’s expenses from its revenues. cost of goods sold the amount of money a firm spent to buy or produce the products it sold during the period to which the income statement applies TABLE 14.4 Consolidated Statements of Earnings for Starbucks (in thousands, except earnings per share) Financing the Enterprise Revenue. Revenue is the total amount of money received (or promised) from the sale of goods or services, as well as from other business activities such as the rental of property and investments. Nonbusiness entities typically obtain revenues through donations from individuals and/or grants from governments and private foundations. Starbucks’ income statement (see Table 14.4) shows one main source of income: sales of Starbucks’ products. For most manufacturing and retail concerns, the next major item included in the income statement is the cost of goods sold, the amount of money the firm Fiscal Year Ended Net revenues: Company-operated retail Specialty: Licensing Foodservice and other Total specialty W I L S O N , Sept 30, 2007 Oct 1, 2006 Oct 2, 2005 $7,998,265 $6,583,098 $5,391,927 1,026,338 860,676 673,015 386,894 343,168 304,358 1,413,232 1,203,844 977,373 Total net revenues 9,411,497 7,786,942 6,369,300 J Cost of sales including occupancy costs 3,999,124 3,178,791 2,605,212 3,215,889 2,687,815 2,165,911 294,136 253,724 192,525 467,160 387,211 340,169 A Other operating expenses M Depreciation and amortization expenses I General and administrative expenses Total operating expenses E Store operating expenses 489,249 479,386 361,613 8,465,558 6,986,927 5,665,430 Income from equity investees Operating income Net interest and other income Earnings before income taxes Income taxes Earnings before cumulative effect of change in accounting principle Cumulative effect of accounting change for FIN 47, net of taxes 93,937 76,648 893,952 780,518 5 0 5 1 B U 108,006 1,053,945 2,419 12,291 15,829 1,056,364 906,243 796,347 383,726 324,770 301,977 672,638 581,473 494,370 — 17,214 — $ 672,638 $ 564,259 $ 494,370 Net earnings—basic $ 0.90 $ 0.74 $ 0.63 Net earnings—diluted $ 0.87 $ 0.71 $ 0.61 Net earnings Per common share: Weighted average shares outstanding: Basic 749,763 766,114 789,570 Diluted 770,091 792,556 815,417 Source: media.corporate-ir.net/media_files/irol/99/99518/2007AR (accessed September 18, 2008). fer11722_ch14_421-457.indd 436 9/23/08 11:27:37 AM Confirming Pages CHAPTER 14 Accounting and Financial Statements 437 spent (or promised to spend) to buy and/or produce the products it sold during the accounting period. This figure may be calculated as follows: Cost of goods sold ⫽ Beginning inventory ⫹ Interim purchases ⫺ Ending inventory Let’s say that Anna’s Flowers began an accounting period with an inventory of goods for which it paid $5,000. During the period, Anna bought another $4,000 worth of goods, giving the shop a total inventory available for sale of $9,000. If, at the end of the accounting period, Anna’s inventory was worth $5,500, the cost of goods sold during the period would have been $3,500 ($5,000 ⫹ $4,000 ⫺ $5,500 ⫽ $3,500). If Anna had total revenues of $10,000 over the same period of time, subtracting the cost of goods sold ($3,500) from the total revenues of $10,000 yields the store’s gross income or profit (revenues minus the cost of goods sold required Wof goods sold was just under to generate the revenues): $6,500. For Starbucks, cost $4 billion in 2007. Notice that Starbucks calls it cost I of sales, rather than cost of goods sold. This is because Starbucks buys raw materials and supplies and produces L drinks. S day-to-day operations of an Expenses. Expenses are the costs incurred in the organization. Three common expense accounts shown O on income statements are (1) selling, general, and administrative expenses; (2) research, development, and engiN neering expenses; and (3) interest expenses (remember that the costs directly attributable to selling goods or services are included in the cost, of goods sold). Selling expenses include advertising and sales salaries. General and administrative expenses include salaries of executives and their staff and the costs of owning and maintaining the general J engineering, and marketing office. Research and development costs include scientific, personnel and the equipment and information usedA to design and build prototypes and samples. Interest expenses include the direct costs of borrowing money. The number and type of expense accounts varyMfrom organization to organization. Included in the general and administrativeI category is a special type of expense known as depreciation, the process of spreading the costs of long-lived assets such as buildings and equipment over the totalEnumber of accounting periods in which they are expected to be used. Consider a manufacturer that purchases a $100,000 machine expected to last about 10 years. Rather than showing an expense of $100,000 in the first year and no expense for that5equipment over the next nine years, the manufacturer is allowed to report depre- 0 ciation expenses of $10,000 per year in each of the next 10 years because that better matches the cost of 5 the machine to the years the machine is used. Each 1 time this depreciation is “written off ” as an expense, B the book value of the machine is also reduced by $10,000. The fact that the equipment has a zero U value on the firm’s balance sheet when it is fully depreciated (in this case, after 10 years) does not necessarily mean that it can no longer be used or is economically worthless. Indeed, in some industries, machines used every day have been reported as having no book value whatsoever for over 30 years. Net Income. Net income (or net earnings) is the total profit (or loss) after all expenses including taxes have been deducted from revenue. Generally, fer11722_ch14_421-457.indd 437 gross income (or profit) revenues minus the cost of goods sold required to generate the revenues expenses the costs incurred in the day-to-day operations of an organization depreciation the process of spreading the costs of long-lived assets such as buildings and equipment over the total number of accounting periods in which they are expected to be used net income the total profit (or loss) after all expenses, including taxes, have been deducted from revenue; also called net earnings Firms and corporations like this lumber mill shown here depreciate, or spread out the cost, of their many assets over a certain number of accounting periods. 9/22/08 2:19:34 PM Rev. Confirming Pages Entrepreneurship in Action Pursuing a Life-Long Dream, a Social Worker and Teacher Gets an A+ for His Goat’s Milk Cheeses Paul Trubey Business: Beltane Farm Founded: Cheese production began in 1999, Beltane Farm was formed in 2002. Success: Trubey’s cheeses have won awards and are popular on the farmer’s market circuit. Paul Trubey always wanted to raise goats. Trained as a social worker, he finally got his wish in 1994. After a move to Lebanon, Connecticut, Trubey decided that he needed a break from working hospice. He took a job teaching Latin for a local school, thinking that he would be able to save some money and move to Massachusetts with his partner so they could start a farm. Fate had other plans for Trubey, however. Dorothy Joba, a co-worker, had goats on the farm she had run with her partner for more than a decade, Highwater Farm. To indulge his desire to work with goats, Trubey began working for Joba on nights and weekends. With Joba’s permission, he began making cheese from the goat milk produced there, experimenting with artisanal recipes. After a while, Joba and Trubey came to the conclusion that he should pursue cheese-making as a profession. The farm was licensed for cheese production in 1999, forming Highwater Dairy LLC. Trubey, who had little business experience, had to learn the ins and outs of finance and accounting in order to record costs and revenues, as well as detail profits for tax purposes. Trubey had to learn on the job because soon after W establishing the dairy, he started selling at the region’s farmer’s markets and to retail stores and restaurants. In 2000, I Trubey’s Chevre won a blue ribbon in the American Cheese Society’s national competition. In 2002, Trubey purchased the L herd from Joba and moved them to Beltane Farm in Lebanon, S Connecticut. Although Trubey is back to part-time hospice work, his business still brings in a profit and his cheeses O remain a farmer’s market favorite; people can also visit the farm N to make purchases.10 , accountants divide profits into individual sections such as operating income and earnings before interest and taxes. Starbucks, for example, lists earnings before J earnings per share of outstanding stock (see income taxes, net earnings, and Table 14.4). Like most companies, A Starbucks presents not only the current year’s results but also the previous two years’ income statements to permit comparison of performance from one period toManother. I Temporary Nature of the Income Statement Accounts. Companies record their operational activities in theErevenue and expense accounts during an accounting period. Gross profit, earnings before interest and taxes, and net income are the results of calculations made from the revenues and expenses accounts; they are not 5 accounting period, the dollar amounts in all the actual accounts. At the end of each revenue and expense accounts 0 are moved into an account called “Retained Earnings,” one of the owners’ equity accounts. Revenues increase owners’ equity, while 5 change in the owners’ equity account is exactly expenses decrease it. The resulting equal to the net income. This shifting 1 of dollar values from the revenue and expense accounts allows the firm to begin the next accounting period with zero balances in those accounts. Zeroing out theB balances enables a company to count how much it has sold and how many expenses Uhave been incurred during a period of time. The basic accounting equation (Assets ⫽ Liabilities ⫹ Owners’ equity) will not balance until the revenue and expense account balances have been moved or “closed out” to the owners’ equity account. One final note about income statements: You may remember from Chapter 5 that corporations may choose to make cash payments called dividends to shareholders out of their net earnings. When a corporation elects to pay dividends, it decreases the cash account (in the assets category of the balance sheet) as well as a capital account (in the owners’ equity category of the balance sheet). During any period of time, the owners’ equity account may change because of the sale of stock (or contributions/ withdrawals by owners), the net income or loss, or from the dividends paid. 438 fer11722_ch14_421-457.indd 438 9/23/08 11:39:49 AM Confirming Pages CHAPTER 14 Accounting and Financial Statements 439 The Balance Sheet The second basic financial statement is the balance sheet, which presents a “snapshot” of an organization’s financial position at a given moment. As such, the balance sheet indicates what the organization owns or controls and the various sources of the funds used to pay for these assets, such as bank debt or owners’ equity. The balance sheet takes its name from its reliance on the accounting equation: Assets must equal liabilities plus owners’ equity. Table 14.5 provides a sample balance sheet with line-by-line explanations. Unlike the income statement, the balance sheet does not represent the result of transactions completed over a specified accounting period. Instead, the balance sheet is, by definition, an accumulation of all financial transactions conducted by an organization since its founding. Following long-established traditions, items on the balance sheet are listed on the basis of W than their present values. their original cost less accumulated depreciation, rather Balance sheets are often presented in two different I formats. The traditional balance sheet format placed the organization’s assets on the left side and its liabilities L and owners’ equity on the right. More recently, a vertical format, with assets on top balance sheet a “snapshot” of an organization’s financial position at a given moment S O TABLE 14.5 Sample Balance Sheet N The following exhibit presents a balance sheet in word form with each item defined or explained. , Typical Company December 31 Assets This is the major category for all physical, monetary, or intangible goods that have some dollar value. J Current assets Assets that are either cash or are expected to be turned into cash within the next 12 months. Cash Marketable securities Accounts receivable Inventory A M Short-term investments in securities that can be converted to cash quickly (liquid assets). Cash due from customers inI payment for goods received. These arise from sales made on credit. E Finished goods ready for sale, goods in the process of being finished, or raw materials Cash or checking accounts. used in the production of goods. Prepaid expense Total current assets Fixed assets Investments Gross property, plant, and equipment Less: Accumulated depreciation A future expense item that has already been paid, such as insurance premiums or rent. 5 Assets that are long term in0 nature and have a minimum life expectancy that exceeds one year. 5 Assets held as investments rather than assets owned for the production process. Most 1 ownership interests in other companies. often the assets include small Land, buildings, and other fixed B assets listed at original cost. U The accumulated expense deductions applied to all plant and equipment over their life. The sum of the above accounts. Land may not be depreciated. The total amount represents in general the decline in value as equipment gets older and wears out. The maximum amount that can be deducted is set by the U.S. Federal Tax Code and varies by type of asset. Net property, plant, and equipment Gross property, plant, and equipment minus the accumulated depreciation. This amount reflects the book value of the fixed assets and not their value if sold. Other assets Any other asset that is long term and does not fit into the above categories. It could be patents or trademarks. Total assets The sum of all the asset values. (continued) fer11722_ch14_421-457.indd 439 9/22/08 2:19:54 PM Confirming Pages 440 PART 6 TABLE 14.5 Financing the Enterprise Sample Balance Sheet (Continued) Liabilities and Stockholders’ Equity This is the major category. Liabilities refer to all indebtedness and loans of both a long-term and short-term nature. Stockholders’ equity refers to all money that has been contributed to the company over the life of the firm by the owners. Current liabilities Short-term debt expected to be paid off within the next 12 months. Accounts payable Money owed to suppliers for goods ordered. Firms usually have between 30 and 90 days to pay this account, depending on industry norms. Wages payable Money owned to employees for hours worked or salary. If workers receive checks every two weeks, the amount owed should be no more than two weeks’ pay. Taxes payable Firms are required to pay corporate taxes quarterly. This refers to taxes owed based on earnings estimates for the quarter. Notes payable Short-term loans from banks or other Wlenders. Other current liabilities The other short-term debts that do not fit into the above categories. Total current liabilities Long-term liabilities Long-term debt Deferred income taxes Other liabilities Stockholders’ equity Common stock Capital in excess of par (a.k.a. contributed capital) I L off in the next 12 months. All long-term debt that will not be paid Loans of more than one year from S banks, pension funds, insurance companies, or other lenders. These loans often take the form of bonds, which are securities that may be bought O and sold in bond markets. This is a liability owed to the government N but not due within one year. Any other long-term debt that does not fit the above two categories. , The sum of the above accounts. The following categories are the owners’ investment in the company. The tangible evidence of ownership is a security called common stock. The par value is stated value and does not indicateJthe company’s worth. When shares of stock were sold to the owners, they were recorded at the price at the time Awas $10 per share, the extra $9 per share would show of the original sale. If the price paid up in this account at 100,000 shares Mtimes $9 per share, or $900,000. Retained earnings The total amount of earnings the company has made during its life and not paid out to its I represents the owners’ reinvestment of earnings stockholders as dividends. This account into company assets rather than payments of cash dividends. This account does not E represent cash. Total stockholders’ equity This is the sum of the above equity accounts representing the owner’s total investment in the company. Total liabilities and stockholders’ equity current assets assets that are used or converted into cash within the course of a calendar year accounts receivable money owed a company by its clients or customers who have promised to pay for the products at a later date fer11722_ch14_421-457.indd 440 5 The total short-term and long-term debt of the company plus the owner’s total investment. This combined amount must equal0 total assets. 5 1 followed by liabilities and owners’ equity, has gained wide acceptance. Starbucks’ balance sheet for 2004 and 2005Bis presented in Table 14.6. In the sections that follow, we’ll briefly describe the basic U items found on the balance sheet; we’ll take a closer look at a number of these in Chapter 16. Assets. All asset accounts are listed in descending order of liquidity—that is, how quickly each could be turned into cash. Current assets, also called short-term assets, are those that are used or converted into cash within the course of a calendar year. Cash is followed by temporary investments, accounts receivable, and inventory, in that order. Accounts receivable refers to money owed the company by its clients or customers who have promised to pay for the products at a later date. Accounts receivable usually includes an allowance for bad debts that management does not expect to collect. The bad-debts adjustment is normally based on historical 9/22/08 2:19:54 PM Rev. Confirming Pages CHAPTER 14 TABLE 14.6 Accounting and Financial Statements 441 Consolidated Balance Sheets (in thousands, except share data) Fiscal Year Ended Sept 30, 2007 Oct 1, 2006 Assets Current assets: Cash and cash equivalents Short-term investments—available-for-sale securities Short-term investments—trading securities $ 281,261 $ 312,606 83,845 87,542 73,588 53,496 Accounts receivable, net 287,925 224,271 Inventories 691,658 636,222 Prepaid expenses and other current assets 148,757 126,874 129,453 88,777 1,696,487 1,529,788 21,022 5,811 Deferred income taxes, net Total current assets Long-term investments—available-for-sale securities Equity and other investments Property, plant and equipment, net Other assets Other intangible assets Goodwill Total Assets W I L S O N , 258,846 219,093 2,890,433 2,287,899 219,422 186,917 42,043 37,955 215,625 161,478 $5,343,878 $4,428,941 $ 710,248 $ 700,000 390,836 340,937 332,331 288,963 74,591 54,868 Liabilities and Shareholders’ Equity Current liabilities: Commercial paper and short-term borrowings Accounts payable Accrued compensation and related costs Accrued occupancy costs Accrued taxes J A M I E 92,516 94,010 Other accrued expenses 257,369 224,154 Deferred revenue 296,900 231,926 5 0 Total current liabilities Long-term debt 5 Other long-term liabilities 1 Total liabilities B Shareholders’ equity: U shares; Common stock ($0.001 par value)—authorized, 1,200,000,000 Current portion of long-term debt issued and outstanding, 738,285,285 and 756,602,701 shares, respectively, (includes 3,420,448 common stock units in both periods) Other additional paid-in-capital Retained earnings Accumulated other comprehensive income Total shareholders’ equity Total Liabilities and Shareholders’ Equity 775 762 2,155,566 1,935,620 550,121 1,958 354,074 262,857 3,059,761 2,200,435 738 756 39,393 39,393 2,189,366 2,151,084 54,620 37,273 2,284,117 2,228,506 $5,343,878 $4,428,941 Source: media.corporate-ir.net/media_files/irol/99/99518/2007AR (accessed September 18, 2008). fer11722_ch14_421-457.indd 441 9/23/08 11:41:54 AM Confirming Pages 442 PART 6 Financing the Enterprise collections experience and is deducted from the accounts receivable balance to present a more realistic view of the payments likely to be received in the future, called net receivables. Inventory may be held in the form of raw materials, work-in-progress, or finished goods ready for delivery. Long-term, or fixed assets represent a commitment of organizational funds of at least one year. Items classified as fixed include long-term investments, plant and equipment, and intangible assets, such as corporate “goodwill,” or reputation, as well as patents and trademarks. current liabilities a firm’s financial obligations to short-term creditors, which must be repaid within one year accounts payable the amount a company owes to suppliers for goods and services purchased with credit accrued expenses is an account representing all unpaid financial obligations incurred by the organization Liabilities. As seen in the accounting equation, total assets must be financed either through borrowing (liabilities) or through owner investments (owners’ equity). Current liabilities include a firm’s financial obligations to short-term creditors, which must be repaid within one Wyear, while long-term liabilities have longer repayment terms. Accounts payable represents amounts owed to suppliers for goods I For example, if you buy gas with a BP credit and services purchased with credit. card, the purchase represents an Laccount payable for you (and an account receivable for BP). Other liabilities include wages earned by employees but not yet paid S Occasionally, these accounts are consolidated and taxes owed to the government. into an accrued expenses account, O representing all unpaid financial obligations incurred by the organization. N Owners’ Equity. Owners’ equity includes the owners’ contributions to the orga, by the organization and retained to finance connization along with income earned tinued growth and development. If the organization were to sell off all of its assets and pay off all of its liabilities, any remaining funds would belong to the owners. J as owners’ equity on a balance sheet may differ Not surprisingly, the accounts listed dramatically from company to company. As mentioned in Chapter 5, corporations A sell stock to investors, who then become the owners of the firm. Many corporations M issue two, three, or even more different classes of common and preferred stock, each I and/or voting rights. Because each type of stock with different dividend payments issued represents a different claim on the organization, each must be represented by E a separate owners’ equity account, called contributed capital. The Statement of Cash Flows statement of cash flows explains how the company’s cash changed from the beginning of the accounting period to the end fer11722_ch14_421-457.indd 442 5 The third primary financial statement is called the statement of cash flows, which explains how the company’s 0 cash changed from the beginning of the accounting period to the end. Cash, of course, is an asset shown on the balance sheet, which 5 provides a snapshot of the firm’s financial position at one point in time. However, 1 of financial statements want more information many investors and other users about the cash flowing into and Bout of the firm than is provided on the balance sheet in order to better understand the company’s financial health. The statement U from one year’s balance sheet and compares it of cash flows takes the cash balance with the next while providing detail about how the firm used the cash. Table 14.7 presents Starbucks’ statement of cash flows. The change in cash is explained through details in three categories: cash from (used for) operating activities, cash from (used for) investing activities, and cash from (used for) financing activities. Cash from operating activities is calculated by combining the changes in the revenue accounts, expense accounts, current asset accounts, and current liability accounts. This category of cash flows includes all the accounts on the balance sheet that relate to computing revenues and expenses for the accounting period. If this amount is a positive number, as it is for Starbucks, 9/22/08 2:19:56 PM Confirming Pages CHAPTER 14 Accounting and Financial Statements 443 then the business is making extra cash that it can use to invest in increased longterm capacity or to pay off debts such as loans or bonds. A negative number may indicate a business that is in a declining position with regards to operations. Negative cash flow is not always a bad thing, however. It may indicate that a business is growing, with a very negative cash flow indicating rapid growth. Cash from investing activities is calculated from changes in the long-term or fixed asset accounts. If this amount is negative, as is the case with Starbucks, the company is purchasing long-term assets for future growth. A positive figure indicates a business that is selling off existing long-term assets and reducing its capacity for the future. TABLE 14.7 Starbucks Consolidated Statements of Cash WFlows (in thousands) Fiscal Year Ended I L Net earnings S Adjustments to reconcile net earnings to net cash provided by operating activities: O Cumulative effect of accounting change for FIN 47, net of taxes N Depreciation and amortization , Provision for impairments and asset disposals Sept 30, 2007 Oct 1, 2006 Oct 2, 2005 Operating Activities: $ 672,638 $ 564,259 $ 494,370 — 17,214 — 491,238 412,625 367,207 26,032 19,622 19,464 Deferred income taxes, net (37,326) (84,324) (31,253) Equity in income of investees (65,743) (60,570) (49,537) 65,927 49,238 30,919 103,865 105,664 — 7,705 1,318 109,978 (93,055) (117,368) — 653 2,013 10,097 (48,576) (85,527) (121,618) 36,068 104,966 9,717 38,628 54,424 22,711 86,371 132,725 14,435 63,233 56,547 53,276 J A Stock-based compensation Tax benefit from exercise of stock options M Excess tax benefit from exercise of stock options I Net amortization of premium on securities E Cash provided/(used) by changes in operating assets and liabilities: Distributions of income from equity investees Inventories Accounts payable Accrued compensation and related costs Accrued taxes Deferred revenue Other operating assets and liabilities Net cash provided by operating activities Investing Activities: Purchase of available-for-sale securities 5 0 5 1 B U Maturity of available-for-sale securities (16,437) (41,193) (6,851) 1,331,221 1,131,633 922,915 (237,422) (639,192) (643,488) 178,167 269,134 469,554 Sale of available-for-sale securities 47,497 431,181 626,113 Acquisitions, net of cash acquired (53,293) (91,734) (21,583) Net purchases of equity, other investments and other assets Net additions to property, plant and equipment Net cash used by investing activities (56,552) (39,199) (7,915) (1,080,348) (771,230) (643,296) (1,201,951) (841,040) (220,615) (continued) fer11722_ch14_421-457.indd 443 9/22/08 2:19:57 PM Rev. Confirming Pages 444 PART 6 TABLE 14.7 Financing the Enterprise Starbucks Consolidated Statements of Cash Flows (in thousands) (Continued) Financing Activities: Repayments of commercial paper (16,600,841) — — Proceeds from issuance of commercial paper 17,311,089 — — Repayments of short-term borrowings (1,470,000) (993,093) — Proceeds from short-term borrowings 770,000 1,416,093 277,000 Proceeds from issuance of common stock 176,937 159,249 163,555 93,055 117,368 — (784) (898) (735) Excess tax benefit from exercise of stock options Principal payments on long-term debt Proceeds from issuance of long-term debt 548,960 — — Repurchase of common stock (996,798) (854,045) (1,113,647) W Other I Net cash used by financing activities L Effect of exchange rate changes on cash and cash equivalents S Net increase/(decrease) in cash and cash equivalents O Cash and Cash Equivalents: Beginning of period N End of the period , (3,505) — — (171,887) (155,326) (673,827) 11,272 3,530 283 (31,345) 138,797 28,756 312,606 173,809 145,053 $ 281,261 $ 312,606 $ 173,809 Supplemental Disclosure of Cash Flow Information: Cash paid during the period for: $ 35,294 $ 10,576 $ 1,060 J Income taxes $ 342,223 $ 274,134 $ 227,812 A Source: media.corporate-ir.net/media_files/irol/99/99518/2007AR (accessed September 18, 2008). M I Finally, cash from financing activities is calculated from changes in the long-term E Interest, net of capitalized interest liability accounts and the contributed capital accounts in owners’ equity. If this amount is negative, the company is likely paying off long-term debt or returning contributed capital to investors.5As in the case of Starbucks, if this amount is positive, the company is either borrowing more money or raising money from investors by selling more shares of stock. 0 5 Ratio Analysis: Analyzing Financial 1 Statements B The income statement shows aUcompany’s profit or loss, while the balance sheet ratio analysis calculations that measure an organization’s financial health fer11722_ch14_421-457.indd 444 itemizes the value of its assets, liabilities, and owners’ equity. Together, the two statements provide the means to answer two critical questions: (1) How much did the firm make or lose? and (2) How much is the firm presently worth based on historical values found on the balance sheet? Ratio analysis, calculations that measure an organization’s financial health, brings the complex information from the income statement and balance sheet into sharper focus so that managers, lenders, owners, and other interested parties can measure and compare the organization’s productivity, profitability, and financing mix with other similar entities. 9/23/08 11:44:14 AM Confirming Pages CHAPTER 14 Accounting and Financial Statements 445 You can look on Web sites like Yahoo! Finance under a company’s “key statistics” link to find many of its financial ratios, such as its return on assets, return on equity, and current ratio. Other ratios require a closer look at a company’s actual financial statements. W I L S by another, with the result As you know, a ratio is simply one number divided showing the relationship between the two numbers. Financial ratios are used to weigh O and evaluate a firm’s performance. An absolute value such as earnings of $70,000 or N as much useful information accounts receivable of $200,000 almost never provides as a well-constructed ratio. Whether those numbers , are good or bad depends on their relation to other numbers. If a company earned $70,000 on $700,000 in sales (a 10 percent return), such an earnings level might be quite satisfactory. The president of a company earning this same $70,000 on sales J of $7 million (a 1 percent return), however, should probably start looking for another job! Ratios by themselves are not very useful. It is theArelationship of the calculated ratios to both prior organizational performance and Mthe performance of the organization’s “peers,” as well as its stated goals, that really matters. Remember, while the I profitability, asset utilization, liquidity, debt ratios, and per share data we’ll look at here can be very useful, you will never see the forest E by looking only at the trees. Profitability Ratios 5 income or net income an Profitability ratios measure how much operating organization is able to generate relative to its assets,0owners’ equity, and sales. The numerator (top number) used in these examples is always the net income after taxes. Common profitability ratios include profit margin, 5 return on assets, and return on equity. The following examples are based on the 2007 1 income statement and balance sheet for Starbucks, as shown in Tables 14.4 and 14.6. Except where specified, B all data are expressed in millions of dollars. The profit margin, computed by dividing net income U by sales, shows the overall percentage profits earned by the company. It is based solely upon data obtained from the income statement. The higher the profit margin, the better the cost controls within the company and the higher the return on every dollar of revenue. Starbucks’ profit margin is calculated as follows: Profit margin ⫽ $672,638 $9,411,487 profitability ratios ratios that measure the amount of operating income or net income an organization is able to generate relative to its assets, owners’ equity, and sales profit margin net income divided by sales ⫽ 7..15% Thus, for every $1 in sales, Starbucks generated profits of just over 7 cents. fer11722_ch14_421-457.indd 445 9/22/08 2:19:58 PM Confirming Pages Consider Ethics and Social Responsibility Holding Companies Responsible: The Public Company Accounting Oversight Board The Financial Accounting Standards Board (FASB) has been establishing standards for financial accounting and reporting in the private sector since 1973. Its main mission is to provide guidance for the utilization of responsible accounting methods, reporting, and policies to protect investors, lenders, and the public. By the turn of the 21st century, however, it was clear that the FASB did not provide strong enough regulatory measures. In response to public outrage surrounding corporate accounting scandals at Enron, WorldCom, and many other firms, in which many thousands of investors and employees lost much of their savings, Congress passed the Sarbanes-Oxley Act (SOX) in 2002 to restore stakeholder confidence in business financial reporting. Among its many provisions, the Sarbanes-Oxley Act established oversight of public corporate governance and financial reporting obligations and redesigned accountability and ethics standards for corporate officers, auditors, and analysts. Before SOX established an oversight mechanism for accounting, it had, to some extent, been self-regulatory. The Sarbanes-Oxley Act established the Public Company Accounting Oversight Board (PCAOB), which oversees the audit of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate, and independent audit reports for companies. The duties of the PCAOB include registration of public accounting firms; establishment of standards for auditing, quality control, ethics, independence, and other issues relating to preparation of audit reports; inspection of accounting firms; investigations, disciplinary actions, and sanctions; and enforcement of compliance through the use of accounting rules of the board, professional standards and securities laws for the preparation and issuance of audit reports, and obligations and liabilities of accountants. The accounting oversight board established by SOX placed considerable government control over the accounting industry and the public firms they serve. The oversight board files reports with the Securities and Exchange Commission (SEC) on an annual basis that include any new established rules and any final disciplinary rulings. The SEC itself is responsible for protecting investors, maintaining fair and efficient markets, and facilitating capital creation. return on assets net income divided by assets While the FASB has been involved in accounting standards for decades, it has butted heads with the SEC from time to time, particularly because the SEC has to approve the FASB’s budget. Essentially, the SEC has a hand in every pot both in the world of private business and in government. Since the 2002 introduction of Sarbanes-Oxley, much adjustment has occurred. Although accounting seems to be straightforward, it is not; and the standards applied to company accounting undergo nearly constant revision. Also under W reconsideration are the organizations in charge of creating these standards. Accounting is critical in that it is used toI create the public’s perception of a company. To this end, there L is a constant battle raging over whether or not accounting should be considered public or private policy. In the heat ofSthe battle are the SEC, the FASB, the PCAOB, the American Institute of Certified Public Accountants (AICPA), public O accounting firms, and the business lobby. The reason for the Nbattle goes back to the Sarbanes-Oxley Act, which was created, as previously mentioned, to clarify and delineate , positions held by all those involved in setting the rules of the accounting. After five years, the SEC has come out on top and is beginning to seriously exert its strength. JThe powerful stance of the current SEC makes businesses nervous A for a number of reasons. First, politicians control the SEC, a situation that can create a sense of imbalance. SecM the SEC’s drive toward one set of standards throughout ond, the global world of business may simplify things, but at the I same time it may make necessary an overhaul of all accounting E practices. Some worry that, although the restrictions created by Sarbanes-Oxley are objectionable to many firms, these may pale in comparison to what the SEC has in mind for 11 the 5 future. 0 Discussion Questions 1. Why do the SEC and the FASB disagree on some account5ing issues? 2.1Why was the Sarbanes-Oxley Act created? 3. Opponents of increased accounting and regulatory overBsight have cited increased costs of complying with SOX Uas a reason it should be repealed—do you think this is a valid complaint? Return on assets, net income divided by assets, shows how much income the firm produces for every dollar invested in assets. A company with a low return on assets is probably not using its assets very productively—a key managerial failing. For its construction, the return on assets calculation requires data from both the income statement and the balance sheet. 446 fer11722_ch14_421-457.indd 446 9/22/08 2:20:01 PM Confirming Pages CHAPTER 14 Return on assets ⫽ Accounting and Financial Statements $672,638 $5,343,878 447 ⫽ 12.59% In the case of Starbucks, every $1 of assets generated a return of around 12.6 percent, or profits of around 12.6 cents per dollar. Stockholders are always concerned with how much money they will make on their investment, and they frequently use the return on equity ratio as one of their key performance yardsticks. Return on equity (also called return on investment [ROI]), calculated by dividing net income by owners’ equity, shows how much income is generated by each $1 the owners have invested in the firm. Obviously, a low return on equity means low stockholder returns and may indicate a need for immediate managerial attention. Because some assets may have been financed with debt not contributed by the owners, the value of theW owners’ equity is usually considerably lower than the total value of the firm’s assets. I Starbucks’ return on equity is calculated as follows: return on equity net income divided by owner’s equity; also called return on investment (ROI) L Return on equity ⫽ $672,638 S ⫽ 29.45% $2,284,117 O For every dollar invested by Starbucks stockholders, the company earned a 29.45 N reason the amount is higher percent return, or 29.45 cents per dollar invested. The than the return on assets is that owners’ equity only, accounts for about 43 percent of Starbucks’ assets, while the other 57 percent is financed by debt. Asset Utilization Ratios J Asset utilization ratios measure how well a firm uses its assets to generate each A more productively will have $1 of sales. Obviously, companies using their assets higher returns on assets than their less efficient competitors. Similarly, managers can M use asset utilization ratios to pinpoint areas of inefficiency in their operations. These I ratios (receivables turnover, inventory turnover, and total asset turnover) relate balE statement. ance sheet assets to sales, which are found on the income The receivables turnover, sales divided by accounts receivable, indicates how many times a firm collects its accounts receivable in one year. It also demonstrates how 5 sales. Obviously, no payments quickly a firm is able to collect payments on its credit means no profits. Starbucks collected its receivables 0 32.7 times per year. The reason the number is so high is that most of Starbucks’ sales are for cash and not credit. asset utilization ratios ratios that measure how well a firm uses its assets to generate each $1 of sales receivables turnover sales divided by accounts receivable 5 Receivables turnover ⫽ $9,411,497 1 $2877,925 ⫽ 32.69 ⫻ B Inventory turnover, sales divided by total inventory, indicates how many times U of a year. A high inventory a firm sells and replaces its inventory over the course inventory turnover sales divided by total inventory turnover ratio may indicate great efficiency but may also suggest the possibility of lost sales due to insufficient stock levels. Starbucks’ inventory turnover indicates that it replaced its 13.6 times lost year, or more than once a month. Inventory turnover ⫽ $9,411,497 $691,6658 ⫽ 13.61 ⫻ Total asset turnover, sales divided by total assets, measures how well an organization uses all of its assets in creating sales. It indicates whether a company is fer11722_ch14_421-457.indd 447 total asset turnover sales divided by total assets 9/22/08 2:20:04 PM Confirming Pages 448 PART 6 Financing the Enterprise using its assets productively. Starbucks generated $1.76 in sales for every $1 in total corporate assets. Total asset turnover ⫽ $9,411,497 $5,3443,878 ⫽ 1.76 ⫻ Liquidity Ratios liquidity ratios ratios that measure the speed with which a company can turn its assets into cash to meet short-term debt current ratio current assets divided by current liabilities quick ratio (acid test) a stringent measure of liquidity that eliminates inventory Liquidity ratios compare current (short-term) assets to current liabilities to indicate the speed with which a company can turn its assets into cash to meet debts as they fall due. High liquidity ratios may satisfy a creditor’s need for safety, but ratios that are too high may indicate that the organization is not using its current assets efficiently. Liquidity ratios are W generally best examined in conjunction with asset utilization ratios because high turnover ratios imply that cash is flowing through an I organization very quickly—a situation that dramatically reduces the need for the type of reserves measured by liquidity ratios. L The current ratio is calculated by dividing current assets by current liabilities. S that for every $1 of current liabilities, the firm Starbucks’s current ratio indicates had $0.79 of current assets on hand. O This number may appear troublesome, and it should be a ratio on which the company keeps a close watch. Overall liquidity has N and 2007. Additionally, accounts receivable has decreased somewhat between 2006 increased over the same time period. , This shows that Starbucks’ asset turnover rate is beginning to slow in addition to decreasing liquidity—all coming at a time of sales and expansion slowdowns for Starbucks. J $1,696,487 Current ratio A⫽ ⫽ 0.79 ⫻ $2,155,566 M The quick ratio (also known as the acid test) is a far more stringent measure I inventory, the least liquid current asset. It meaof liquidity because it eliminates sures how well an organizationE can meet its current obligations without resorting to the sale of its inventory. In 2007, Starbucks had just 47 cents invested in current assets (after subtracting inventory) for every $1 of current liabilities, a slight increase over 2006. 5 Quick ratio 0 ⫽ debt utilization ratios ratios that measure how much debt an organization is using relative to other sources of capital, such as owners’ equity fer11722_ch14_421-457.indd 448 $1,004,829 $2,155,566 ⫽ 0..47 ⫻ 5 1 Debt Utilization Ratios B information about how much debt an organizaDebt utilization ratios provide tion is using relative to other sources U of capital, such as owners’ equity. Because the use of debt carries an interest charge that must be paid regularly regardless of profitability, debt financing is much riskier than equity. Unforeseen negative events such as recessions affect heavily indebted firms to a far greater extent than those financed exclusively with owners’ equity. Because of this and other factors, the managers of most firms tend to keep debt-to-asset levels below 50 percent. However, firms in very stable and/or regulated industries, such as electric utilities, often are able to carry debt ratios well in excess of 50 percent with no ill effects. 9/22/08 2:20:05 PM Confirming Pages CHAPTER 14 Accounting and Financial Statements The debt to total assets ratio indicates how much of the firm is financed by debt and how much by owners’ equity. To find the value of Starbucks’ total debt, you must add current liabilities to long-term debt and other liabilities. $3,059,7617 $5,3443,878 Debt to total assets ⫽ ⫽ 57.26% Thus, for every $1 of Starbucks’ total assets, nearly 57.3 percent is financed with debt. The remaining 42.7 percent is provided by owners’ equity. The times interest earned ratio, operating income divided by interest expense, is a measure of the safety margin a company has with respect to the interest payments it must make to its creditors. A low times interest earned ratio indicates that even a small decrease in earnings may lead the company into financial straits. Wexpense, it would appear that Since Starbucks has more interest income than interest their times interest earned ratio is not able to be calculated I by using the income statement. However, in the statement of cash flows in Table 14-7 on the second line from L the bottom, we can see that Starbucks, just under $35.3 million in interest expense, S before interest and taxes. an amount that was covered nearly 29.9 times by income A lender would probably not have to worry about receiving interest payments. O Times interest earned ⫽ $1,053,945 N $35,, 294 449 debt to total assets ratio a ratio indicating how much of the firm is financed by debt and how much by owners’ equity times interest earned ratio operating income divided by interest expense ⫽ 29.86 ⫻ , Per Share Data Investors may use per share data to compare theJperformance of one company with another on an equal, or per share, basis. Generally, the more shares of stock a company issues, the less income is available for eachA share. Earnings per share is calculated by dividing net Mincome or profit by the number of shares of stock outstanding. This ratio is important because yearly changes I in earnings per share, in combination with other economywide factors, determine a company’s overall stock price. When earnings goE up, so does a company’s stock price—and so does the wealth of its stockholders. Diluted earnings per share ⫽ $672,638 5 $7770,091 ⫽ 0.87 (2007) ⫽ $564,2595 $792, 556 ⫽ 0.71 (2006) 0 per share data data used by investors to compare the performance of one company with another on an equal, per share basis earnings per share net income or profit divided by the number of stock shares outstanding 1 We can see from the income statement that Starbucks’ basic earnings per share B increased from $0.74 in 2006 to $0.90 in 2007. Notice that Starbucks lists diluted U and $0.87 for 2007. You can earnings per share, calculated here, of $0.71 for 2006 see from the income statement that diluted earnings per share include more shares than the basic calculation; this is because diluted shares include potential shares that could be issued due to the exercise of stock options or the conversion of certain types of debt into common stock. Investors generally pay more attention to diluted earnings per share than basic earnings per share. Dividends per share are paid by the corporation to the stockholders for each share owned. The payment is made from earnings after taxes by the corporation but fer11722_ch14_421-457.indd 449 dividends per share the actual cash received for each share owned 9/22/08 2:20:05 PM Confirming Pages 450 PART 6 Financing the Enterprise is taxable income to the stockholder. Thus, dividends result in double taxation: The corporation pays tax once on its earnings, and the stockholder pays tax a second time on his or her dividend income. Starbucks has never paid a dividend, so the calculation of dividends per share does not apply in this case. Dividends per share ⫽ $0 $770,091 ⫽ 0 Industry Analysis We have used McDonald’s as a comparison to Starbucks because there are no real national and international coffee houses that compete with Starbucks on the same scale. While McDonald’s is almost four times larger than Starbucks in terms of sales, W they both have a national and international presence and to some extent compete for the consumer’s dollars. Table 14.8 shows that while McDonald’s earns more I profit per dollar of sales, Starbucks earns more dollars per dollar of invested assets. L shop is much less expensive to build and operate This is because a Starbucks coffee than a McDonald’s. Both companies S have very little accounts receivable relative to the size of their sales. McDonald’s pushes off much of its inventory holding costs on its suppliers and so has muchOless inventory per sales dollar compared with Starbucks. Because McDonald’s hasN very little inventory, its current ratio is almost the same, and its quick ratio is much higher than Starbucks. This is of little consequence , to the financial analyst because both companies have high times interest earned ratios, with Starbucks significantly higher than McDonald’s. Starbucks earns less per share than McDonald’s, butJMcDonald’s pays a dividend and Starbucks does not. In summary, both companies are in good financial health, and it is hard to A say which company is better managed. One thing for sure, if Starbucks could earn the same profit margin as McDonald’s, they would improve their other profitability M ratios dramatically. I E TABLE 14.8 Industry Analysis Starbucks Profit margin Return on assets Return on equity Receivable turnover Inventory turnover Total asset turnover Current ratio Quick ratio Debt to total assets Times interest earned 5 0 5 1 B U McDonald’s 7.15% 10.51% 12.59% 8.15% 29.45% 15.67% 32.69⫻ 21.64⫻ 13.61⫻ 182.30⫻ 1.76⫻ 0.78⫻ 0.79⫻ 0.80⫻ 0.47⫻ 0.77⫻ 57.26% 48.01% 29.86⫻ 9.46⫻ Earnings per share $ 0.87 $ 1.98 Dividends per share $ 0.00 $ 1.50 By tracking and analyzing the financial data of 18 million-plus U.S. businesses, BizMiner.com is able to deliver industry analysis information to its online subscribers. fer11722_ch14_421-457.indd 450 9/22/08 2:20:09 PM Confirming Pages CHAPTER 14 Accounting and Financial Statements 451 So You Want to Be an Accountant Do you like numbers and finances? Are you detail oriented, a perfectionist, and highly accountable for your decisions? If so, accounting may be a good field for you. If you are interested in accounting, there are always job opportunities available no matter the state of the economy. Accounting is one of the most secure job options in business. Of course, becoming an accountant is not easy. You will need at least a bachelor’s degree in accounting to get a job, and many positions require additional training. Many states demand coursework beyond the 120 to 150W credit hours collegiate programs require for an accounting degree. If you are really serious about getting into theI accounting field, you will probably want to consider get-L ting your master’s in accounting and taking the CPA exam. The field of accounting can be complicated, and the extraS training provided through a master’s in accounting pro-O gram will prove invaluable when you go out looking for N a good job. Accounting is a volatile discipline affected by changes in legislative initiatives. , With corporate accounting policies changing constantly and becoming more complex, accountants are needed to help keep a business running smoothly andJ within the bounds of the law. In fact, the number of jobs inA the accounting and auditing field are expected to increase 18 percent between 2006 and 2016, with more than 1.5M million jobs in the United States alone by 2016. Jobs inI accounting tend to pay quite well, with the national average salary standing at just over $57,000 annually. If you go on to get your master’s degree in accounting, expect to see an even higher starting wage. In 2006, accountants with a bachelor’s degree received an average opening offer of $47,618, while employees with master’s degrees were offered $49,277 starting. Of course, your earnings could be higher or lower than these averages, depending on where you work, your level of experience, the firm, and your particular position. Accountants are needed in the public and the private sectors, in large and small firms, in for-profit and not-forprofit organizations. Accountants in firms are generally in charge of preparing and filing tax forms and financial reports. Public-sector accountants are responsible for checking the veracity of corporate and personal records in order to prepare tax filings. Basically, any organization that has to deal with money and/or taxes in some way or another will be in need of an accountant, either for inhouse service or occasional contract work. Requirements for audits under the Sarbanes Oxley Act and rules from the Public Company Accounting Oversight Board are creating more jobs and increased responsibility to maintain internal controls and accounting ethics. The fact that accounting rules and tax filings tend to be complex virtually assures that the demand for accountants will never decrease.12 E Review Your Understanding 5 Define accounting, and describe the different uses of 0 accounting information. Accounting is the language businesses and other orga-5 nizations use to record, measure, and interpret financial 1 transactions. Financial statements are used internally to judge and control an organization’s performance andB to plan and direct its future activities and measure goal attainment. External organizations such as lenders, gov-U ernments, customers, suppliers, and the Internal Revenue Service are major consumers of the information generated by the accounting process. Demonstrate the accounting process. Assets are an organization’s economic resources; liabilities, debts the organization owes to others; owners’ equity, and the difference between the value of an organization’s assets and liabilities. This principle can be expressed as fer11722_ch14_421-457.indd 451 the accounting equation: Assets ⫽ Liabilities ⫹ Owners’ equity. The double-entry bookkeeping system is a system of recording and classifying business transactions in accounts that maintain the balance of the accounting equation. The accounting cycle involves examining source documents, recording transactions in a journal, posting transactions, and preparing financial statements on a continuous basis throughout the life of the organization. Decipher the various components of an income statement in order to evaluate a firm’s “bottom line.” The income statement indicates a company’s profitability over a specific period of time. It shows the “bottom line,” the total profit (or loss) after all expenses (the costs incurred in the day-to-day operations of the organization) have been deducted from revenue (the total amount of money received from the sale of goods or services and 9/22/08 2:20:10 PM Confirming Pages 452 PART 6 Financing the Enterprise other business activities). The cash flow statement details how much cash is moving through the firm and thus adds insight to a firm’s “bottom line.” Interpret a company’s balance sheet to determine its current financial position. The balance sheet, which summarizes the firm’s assets, liabilities, and owners’ equity since its inception, portrays its financial position as of a particular point in time. Major classifications included in the balance sheet are current assets (assets that can be converted to cash within one calendar year), fixed assets (assets of greater than one year’s duration), current liabilities (bills owed by the organization within one calendar year), long-term liabilities (bills due more than one year hence), and owners’ equity (the net value of the owners’ investment). Analyze financial statements, using ratio analysis, to evaluate a company’s performance. Ratio analysis is a series of calculations that brings the complex information from the income statement and balance sheet into sharper focus so that managers, lenders, Revisit the World of Business 1. It is difficult to encourage competition in basic service industries, like phone service. What might Calderón suggest to Slim that could allow for increased competition? Learn the Terms accounting 425 accounting cycle 431 accounting equation 431 accounts payable 442 accounts receivable 440 accrued expenses 442 annual report 429 asset utilization ratios 447 assets 430 balance sheet 439 budget 428 cash flows 428 certified management accountants (CMAs) 427 cert...
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Business of the Changing World
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Budgeting is very important in a business. The budgeting process involves forecasting the
expenses and incomes of the business. A budged gives a clear roadmap to the members of an
organization on any future expenditure. A budget also helps an organization to plan its finances
for any activities and projects that may require financing by the business. Bud...


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